49134195 Petrozuata Analysis Writeup

﻿EXECUTIVE SUMMARYCompanies are increasingly using project finance to fund large-scale capital expenditures. The decision to use project finance involves an explicit choice regarding both organizational form and financial structure. With project finance, sponsoring firms create legally distinct entities to develop, manage and finance the project. Borrowing occurs on a limited or non-recourse basis and despite this, projects are highly leveraged entities. Debt to total capitalization ratios average 60-70%. The issue explored in the write up below is why firms use project finance instead of traditional, on-balance sheet corporate finance. The notion/argument that in the right settings, project finance allows firms to minimize the net costs associated with market imperfections such as taxes, transaction costs etc is explored below. At the same time, project finance allows firms to manage risks more effectively and more efficiently. These factors make project finance a lower-cost alternative to conventional corporate finance. Costs and benefits of using project finance, major risks and mitigation of these risks as well as evaluation of debt alternatives are all explored below using the Petrozuata deal as an example. PDVSA should ultimately finance the development of the Orinoco Basin using project finance and a detailed explanation can be found below. PROJECT FINANCE – COSTS AND BENEFITS OF USING PROJECT FINANCE Project Finance involves a corporate sponsor investing in and owning a single purpose, industrial asset through a legally independent entity financed with non-recourse debt. The decision to finance this deal on a project basis was actually a dual decision regarding both financial and organizational structure. Instead of entering into a joint venture with Conoco, PDVSA could have build the project alone and relied on spot market transactions to sell the syncrude. However PDVSA would have needed specialized assets to extract and upgrade the syncrude which would have left it vulnerable to potential opportunistic behavior by its downstream customers. Alternatively Conoco could have decided to build the project itself since it already had the downstream refining capacity. Venezuelan law however would prevent Conoco from going it alone as it prohibits foreign ownership of domestic hydrocarbon resources. So a joint venture with a long-term off-take arrangement was created as a way to encourage investment in specialized assets, limit ex post bargaining costs and deter opportunistic behavior. Structured in this fashion, Petrozuata had all the hallmarks of project finance deals i.e. it was an operating company with a limited life (35 years), it was an economically and legally independent entity and it was funded with non-recourse debt. So Petrozuata could definitely be classified as a project. The three characteristics listed above distinguish project finance from traditional corporate finance. To explain the costs and benefits of using project finance, let’s start with M&M’s capital structure irrelevance proposition which holds that firm value should not depend on how a firm finances its investments. So whether a firm uses corporate or project finance to raise funds should be a matter of indifference to its shareholders. A lot of assumptions are baked in here for example, no taxes, no transaction costs, no costs of financial distress. Capital markets however are not perfect so in the real world, in addition to taxes, transactions costs, costs of financial distress, there are costs stemming from incentive conflicts among managers, shareholders and creditors as well as from asymmetric information between corporate insiders and outsiders. Let’s take each of these factors one by one: Project finance reduces corporate taxes – The creation of an independent entity allows projects to obtain tax benefits that are not available to their sponsors. In this case, Petrozuata will pay reduced royalty rates on oil revenue and income tax...

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Petrolera Zuata, Petrozuata C.A.
Students:
Kausik Ash |
Javier Echave |
Trang Ho |
Sarah Nash |
Ayse Zeynep Saka |
Raj Sambasivan |
1a Financing of Orinoco Basin
The generally understood criterion for using project finance to fund a project and Petrozuata's compliance comparison are as below;
Legally independent company = Once the project was completed, Petrozuata would become a stand-alone entity, with the sponsors warranty coming to an end
Non-recourse debt = at completion the project debt would also become non-recourse to the sponsors.
Sponsor holding most of the equity are also suppliers/customers = Conoco would purchase the first 104,000 BPCD from Petrozuata upon production,
Single purpose capital asset = While the project was an integrated facility of production, transportation and refining, the main purpose was to sell syncrude.
Finite life = Petrozuata had a life time of 35 years.
In light with the above, Petrozuata's financing was fit for project financing.
1b Costs and benefits of using project finance
Under the benefits of using project finance the following can be listed; it is cheaper to fund Petrozuata as project than in comparison to PDVSA to do it internally because PDVSA is rated as B whereas Dupont is rated as AA-; it is easier to secure an undisrupted cashflow for the project; PVSA plans further projects to fund such a Sincor. Since it would have...

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PROJECT FINANCE:
PETROLERA ZUATA, PETROZUATA C.A.
To convince the rating agencies of Petrozuata as an excellent opportunity for the sponsors and potential lenders, the deal structure must effectively mitigate risks associated to whether the project is financed through Project Financing or Debt Financing.
Project Financing
Benefits
- PDVSA can get into a joint venture with a private firm
Higher flexibility from preserved debt capacity
More foreign investments from larger private markets
Reduced corporate taxes, tax rate reductions and tax holidays in project finance deals
Payment of 34% income tax versus 67.7% income tax rate if financed by Maraven
Costs
High cost of political risk insurance would increase debt interest rate
High transaction costs from negotiating the deal structure
Debt Financing
Benefits
Bank debt allows withdrawal flexibility
Public bond market allows long maturity and fixed interest rates
144A bond market allows can be underwritten within six months
Costs
Bank debt takes longer processing and has short maturities
Public bond market cannot earn higher return than the cost of borrowing
144A bond market can only be sold back to Qualified Institutional Buyers
Operating risks associated to Petrozuata’s deal structure are Pre-Completion, Post-Completion, and Political risks
1. Pre-completion risks occur when there are no operations due to zero cash flows from investments. These risks...

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Q3. AS CURRENTLY ENVISIONED, DEBT WILL COMPROMISE OF 60% OF THE FUNDS NEEDED FORTHE PROJECT. WOULD YOU RECOMMEND A HIGHER OR A LOWER LEVERAGE RATIO? WHATHAPPENS TO THE MINIMUM DSCR AND IRR ON EQUITY AS THE PROJECT LEVERAGE INCREASESTO 70% OF THE PROJECT FUNDS? DECREASES BY 50%?Soln.
We would recommend that the debt should compromise of the already decided 60% level of thetotal funds. This recommendation I based on the following findings and reasons:
1. At 60% leverage the firm earns an IRR of 26% which gives it measurable gains when compared to the cost of equity of 21%.
Hence giving a definite 5% benefits over equity investment.
2. At 60% leverage the DSCR for the initial years is around 2.06X and thereby increasing givingit enough margins to easily get an investment grade rating.
3. Also, at 60% leverage the DSCR is sufficient enough to cover the interest debt expenses incase of any price fluctuations, thereby covering the risk of price volatility and exchange ratevolatility.
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Hence a higher leverage is not recommended.
5. At lower leverage of 50%, the net IRR is 22% which is comparable to the cost of equity of 21%.
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